Double Earnings Drops Equals Double Trouble

In the past 30 years, we have had seven instances of sequential earnings drops of 7% or greater. In each case, it was not a positive - and a stock market correction reflected the downturn in economic activity. There is a key distinction when referring to sequential earnings declines:

In five out of the seven times, the sequential drop was limited to one quarter (see blue vertical lines above) - meaning the following quarter came in above the previous quarter where there was the precipitous earnings drop of more than 7% sequentially.

In those five instances, the market recovered after the correction and did not make new lows.

In the two out of seven times that you had sequential earnings drops of 7% or greater AND the quarter after the big drop was also lower by any amount, it led to lower lows and continued deterioration (see red vertical lines above).

Why is this important?

From Q3 2018 to Q4 2018 we had the first sequential earnings drop of 7.39%. We also got a big stock market correction of ~20% to go along with it. In five out of seven instances, it's not a problem. Maybe one can partially retrace the bounce before making eventual new highs (like 2011), but the low is in.

This time is currently worrisome and here is why: At present, operating earnings for the S&P 500 for Q1 2019 are also expected to decline sequentially from Q4 2018 earnings. This only happened in 2007 and 2000. Keep in mind, two instances is not a large enough sample to expect the same result with certainty - but it is enough to be mindful and watch it carefully (earnings for Q1 2019).

Can this outcome potentially be avoided? Yes! Expectations are more often than not lower than what is actually reported and in this case they would have to be off by 2.66% (the expected decline). Which is highly possible. Couple that with the possibility of a positive outcome with China/Brexit (which will yield better forward guidance) and we avert the ominous outcome ascribed to 2 quarters of sequential consecutive earnings declines.

T.J. Hayes is Founder, Chairman and Managing Member of Great Hill Capital, LLC (a long/short equity manager based in New York City). He started Hedge Fund ...
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T.J. Hayes is Founder, Chairman and Managing Member of Great Hill Capital, LLC (a long/short equity manager based in New York City). He started Hedge Fund Tips as a platform to share actionable insights, tips and research for investors/traders to benefit from – based on what he has learned in his years of experience in the Hedge Fund industry.